Choosing the Road to Prosperity

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1 Choosing the Road to Prosperity Why We Must End Too Big to Fail Now 2011 ANNUAL REPORT FEDERAL RESERVE BANK OF DALLAS

2 The too-big-to-fail institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism. It is imperative that we end TBTF. Contents Letter from the President 1 Choosing the Road to Prosperity 2 Year in Review 24 Senior Management, Officers and Advisory Councils 26 Boards of Directors 28 Financial/Audit 32

3 Letter from the President I f you are running one of the too-bigto-fail (TBTF) banks alternatively known as systemically important financial institutions, or SIFIs I doubt you are going to like what you read in this annual report essay written by Harvey Rosenblum, the head of the Dallas Fed s Research Department, a highly regarded Federal Reserve veteran of 40 years and the former president of the National Association for Business Economics. Memory fades with the passage of time. Yet it is important to recall that it was in recognition of the precarious position in which the TBTF banks and SIFIs placed our economy in 2008 that the U.S. Congress passed into law the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank). While the act established a number of new macroprudential features to help promote financial stability, its overarching purpose, as stated unambiguously in its preamble, is ending TBTF. However, Dodd Frank does not eradicate TBTF. Indeed, it is our view at the Dallas Fed that it may actually perpetuate an already dangerous trend of increasing banking industry concentration. More than half of banking industry assets are on the books of just five institutions. The top 10 banks now account for 61 percent of commercial banking assets, substantially more than the 26 percent of only 20 years ago; their combined assets equate to half of our nation s GDP. Further, as Rosenblum argues in his essay, there are signs that Dodd Frank s complexity and opaqueness may even be working against the economic recovery. In addition to remaining a lingering threat to financial stability, these megabanks significantly hamper the Federal Reserve s ability to properly conduct monetary policy. They were a primary culprit in magnifying the financial crisis, and their presence continues to play an important role in prolonging our economic malaise. There are good reasons why this recovery has remained frustratingly slow compared with periods following previous recessions, and I believe it has very little to do with the Federal Reserve. Since the onset of the Great Recession, we have undertaken a number of initiatives some orthodox, some not to revive and kick-start the economy. As I like to say, we ve filled the tank with plenty of cheap, high-octane gasoline. But as any mechanic can tell you, it takes more than just gas to propel a car. The lackluster nature of the recovery is certainly the byproduct of the debt-infused boom that preceded the Great Recession, as is the excessive uncertainty surrounding the actions or rather, inactions of our fiscal authorities in Washington. But to borrow an analogy Rosenblum crafted, if there is sludge on the crankshaft in the form of losses and bad loans on the balance sheets of the TBTF banks then the bank-capital linkage that greases the engine of monetary policy does not function properly to drive the real economy. No amount of liquidity provided by the Federal Reserve can change this. Perhaps the most damaging effect of propagating TBTF is the erosion of faith in American capitalism. Diverse groups ranging from the Occupy Wall Street movement to the Tea Party argue that government-assisted bailouts of reckless financial institutions are sociologically and politically offensive. From an economic perspective, these bailouts are certainly harmful to the efficient workings of the market. I encourage you to read the following essay. The TBTF institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism. It is imperative that we end TBTF. In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Only then can the process of creative destruction which America has perfected and practiced with such effectiveness that it led our country to unprecedented economic achievement work its wonders in the financial sector, just as it does elsewhere in our economy. Only then will we have a financial system fit and proper for serving as the lubricant for an economy as dynamic as that of the United States. Richard W. Fisher Annual Report

4 As a nation, we face a distinct choice. We can perpetuate too big to fail, with its inequities and dangers, or we can end it. Eliminating TBTF won t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance Annual Report

5 Choosing the Road to Prosperity Why We Must End Too Big to Fail Now by Harvey Rosenblum M ore than three years after a crippling financial crisis, the American economy still struggles. Growth sputters. Job creation lags. Unemployment remains high. Housing prices languish. Stock markets gyrate. Headlines bring reports of a shrinking middle class and news about governments stumbling toward bankruptcy, at home and abroad. Ordinary Americans have every right to feel anxious, uncertain and angry. They have every right to wonder what happened to an economy that once delivered steady progress. They have every right to question whether policymakers know the way back to normalcy. American workers and taxpayers want a broad-based recovery that restores confidence. Equally important, they seek assurance that the causes of the financial crisis have been dealt with, so a similar breakdown won t impede the flow of economic activity. The road back to prosperity will require reform of the financial sector. In particular, a new roadmap must find ways around the potential hazards posed by the financial institutions that the government not all that long ago deemed too big to fail or TBTF, for short. In 2010, Congress enacted a sweeping, new regulatory framework that attempts to address TBTF. While commendable in some ways, the new law may not prevent the biggest financial institutions from taking excessive risk or growing ever bigger. TBTF institutions were at the center of the financial crisis and the sluggish recovery that followed. If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy. As a nation, we face a distinct choice. We can perpetuate TBTF, with its inequities and dangers, or we can end it. Eliminating TBTF won t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance Annual Report

6 When competition declines, incentives often turn perverse, and self-interest can turn malevolent. That s what happened in the years before the financial crisis. Flaws, Frailties and Foibles The financial crisis arose from failures of the banking, regulatory and political systems. However, focusing on faceless institutions glosses over the fundamental fact that human beings, with all their flaws, frailties and foibles, were behind the tumultuous events that few saw coming and that quickly spiraled out of control. Complacency Good times breed complacency not right away, of course, but over time as memories of past setbacks fade. In 1983, the U.S. entered a 25-year span disrupted by only two brief, shallow downturns, accounting for just 5 percent of that period (Exhibit 1). The economy performed unusually well, with strong growth, low unemployment and stable prices. This period of unusual stability and prosperity has been dubbed the Great Moderation, a respite from the usual tumult of a vibrant capitalist economy. Before the Federal Reserve s founding in 1913, recession held the economy in its grip 48 percent of the time. In the nearly 100 years since the Fed s creation, the economy has been in recession about 21 percent of the time. When calamities don t occur, it s human nature to stop worrying. The world seems less risky. Moral hazard reinforces complacency. Moral hazard describes the danger that protection against losses encourages riskier behavior. Government rescues of troubled financial institutions encourage banks and their creditors to take greater risks, knowing they ll reap the rewards if things turn out well, but will be shielded from losses if things sour. In the run-up to the crisis of 2008, the public sector grew complacent and relaxed the financial system s constraints, explicitly in law and implicitly in enforcement. Additionally, government felt secure enough in prosperity to pursue social engineering goals most notably, expanding home ownership among low-income families. At the same time, the private sector also became complacent, downplaying the risks of borrowing and lending. For example, the traditional guideline of 20 percent down payment for the purchase of a home kept slipping toward zero, especially among lightly regulated mortgage companies. More money went to those with less ability to repay. 1 Greed You need not be a reader of Adam Smith to know the power of self-interest the human desire for material gain. Capitalism couldn t operate without it. Most of the time, competition and the rule of law provide market discipline that keeps self-interest in check and steers it toward the social good of producing more of what consumers want at lower prices. When competition declines, incentives often turn perverse, and self-interest can turn malevolent. That s what happened in the years before the financial crisis. New technologies and business practices reduced lenders skin in the game for example, consider how lenders, instead of retaining the mortgages they made, adopted the new originate-to-distribute model, allowing them to pocket huge fees for making loans, packaging them into securities and selling them to investors. Credit default swaps fed the mania for easy money by opening a casino of sorts, where investors placed bets on and a few financial institutions sold protection on companies creditworthiness. Greed led innovative legal minds to push the boundaries of financial integrity Annual Report

7 with off-balance-sheet entities and other accounting expedients. Practices that weren t necessarily illegal were certainly misleading at least that s the conclusion of many postcrisis investigations. 2 Complicity We admire success. When everybody s making money, we re eager to go along for the ride even in the face of a suspicion that something may be amiss. Before the financial crisis, for example, investors relied heavily on the credit-rating companies that gave a green light to new, highly complex financial products that hadn t been tested under duress. The agencies bestowed their top rating to securities backed by high-risk assets most notably mortgages with small down payments and little documentation of the borrowers income and employment. Billions of dollars of these securities were later downgraded to junk status. Complicity extended to the public sector. The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets. Congress pushed Fannie Mae and Freddie Mac, the de facto government-backed mortgage Exhibit 1 Reduced Time Spent in Recession Time spent in recession (percent) SOURCE: National Bureau of Economic Research. Time spent in recession, pre-fed vs. post (percent) Annual Report 5

8 Concentration amplified the speed and breadth of the subsequent damage to the banking sector and the economy as a whole. Exhibit 2 U.S. Banking Concentration Increased Dramatically 12,500 smaller banks 46% Assets as a percentage of total industry assets Top 5 banks 17% 5,700 smaller banks 16% 37% 32% 95 large and medium-sized banks 52% Top 5 banks NOTE: Assets were calculated using the regulatory high holder or top holder for a bank and summing assets for all the banks with the same top holder to get an estimate of organization-level bank assets. SOURCES: Reports of Condition and Income, Federal Financial Institutions Examination Council; National Information Center, Federal Reserve System. giants, to become the largest buyers of these specious mortgage products. Hindsight leaves us wondering what financial gurus and policymakers could have been thinking. But complicity presupposes a willful blindness we see what we want to see or what life s experiences condition us to see. Why spoil the party when the economy is growing and more people are employed? Imagine the political storms and public ridicule that would sweep over anyone who tried! Exuberance Easy money leads to a giddy selfdelusion it s human nature. A contagious divorce from reality lies behind many of history s great speculative episodes, such as the Dutch tulip mania of 1637 and the South Sea bubble of Closer to home in time and space, exuberance fueled the Texas oil boom of the early 1980s. In the first decade of this century, it fed the illusion that housing prices could rise forever. In the run-up to the financial crisis, the certainty of rising housing prices convinced some homebuyers that highrisk mortgages, with little or no equity, weren t that risky. It induced consumers Annual Report

9 to borrow on rising home prices to pay for new cars, their children s education or a long-hoped-for vacation. Prudence would have meant sitting out the dance; buying into the exuberance gave people what they wanted at least for a while. All booms end up busts. Then comes the sad refrain of regret: How could we have been so foolish? Concentration In the financial crisis, the human traits of complacency, greed, complicity and exuberance were intertwined with concentration, the result of businesses natural desire to grow into a bigger, more important and dominant force in their industries. Concentration amplified the speed and breadth of the subsequent damage to the banking sector and the economy as a whole. The biggest U.S. banks have gotten a lot bigger. Since the early 1970s, the share of banking industry assets controlled by the five largest U.S. institutions has more than tripled to 52 percent from 17 percent (Exhibit 2). Mammoth institutions were built on a foundation of leverage, sometimes misleading regulators and investors through the use of off-balance-sheet financing. 3 Equity s share of assets dwindled as banks borrowed to the hilt to chase the easy profits in new, complex and risky financial instruments. Their balance sheets deteriorated too little capital, too much debt, too much risk. The troubles weren t always apparent. Financial institutions kept marking assets on their books at acquisition cost and sometimes higher values if their proprietary models could support such valuations. These accounting expedients allowed them to claim they were healthy until they weren t. Write-downs were later revised by several orders of magnitude to acknowledge mounting problems. With size came complexity. Many big banks stretched their operations to include proprietary trading and hedge fund investments. They spread their reach into dozens of countries as financial markets globalized. Complexity magnifies the opportunities for obfuscation. Top management may not have known all of what was going on particularly the exposure to risk. Regulators didn t have the time, manpower and other resources to oversee the biggest banks vast operations and ferret out the problems that might be buried in financial footnotes or legal boilerplate. These large, complex financial institutions aggressively pursued profits in the overheated markets for subprime mortgages and related securities. They pushed the limits of regulatory ambiguity and lax enforcement. They carried greater risk and overestimated their ability to manage it. In some cases, top management groped around in the dark because accounting and monitoring systems didn t keep pace with the expanding enterprises. Blowing a Gasket In normal times, flows of money and credit keep the economy humming. A healthy financial system facilitates payments and transactions by businesses and consumers. It allocates capital to competing investments. It values assets. It prices risk. For the most part, we take the financial system s routine workings for granted until the machinery blows a gasket. Then we scramble to fix it, so the economy can return to the fast lane. In 2007, the nation s biggest investment and commercial banks were among the first to take huge write-offs on mortgage-backed securities (Exhibit 3). (continued on page 11) 2011 Annual Report 7

10 Exhibit 3 Employment Plummets as Financial System Implodes Selected Timeline, Trouble starts with shadow banks Crisis spreads to larger shadow/investment banks Commercial banks are affected Smaller banks struggle amid a mixed recovery 300 Investment banks Month over month change in private nonfarm payrolls (thousands) Losses spread to investors in subprime mortgage-backed securities; Bear Stearns fights unsuccessfully to save two ailing hedge funds (6/07) Subprime mortgage lenders show losses and some go bankrupt: New Century Financial (4/07) Subprime mortgage-related and leveraged loan losses mount amid serial restatements of write-downs; execs at Citi and Merrill Lynch step down (07:Q4) acquired by largest commercial banks with government assistance: Bear Stearns (3/08); Merrill Lynch (1/09) Monoline insurers downgraded (6/08) Bank/thrift failures: IndyMac (7/08); Washington Mutual (9/08) Nationalization of systemically important mortgage-lending institutions: Northern Rock (2/08); Fannie Mae and Freddie Mac (9/08) Financial market disarray Lehman bankruptcy; AIG backstopped (9/08) Banking behemoth consolidation Wells Fargo acquires Wachovia; PNC acquires National City; Goldman Sachs and Morgan Stanley become bank holding companies (10/08) Government intervention Citi and Bank of America receive government guarantees; troubled asset relief program (TARP) funds released, restrictions on exec pay, stress tests introduced; Fed pushes policy rate near zero, creates special liquidity and credit facilities and introduces largescale asset purchases (08:Q4 09:Q1) Small banks face rising uncertainty about compliance costs, unknown implementation of complicated new regulations and anemic loan demand Roughly 800,000 jobs lost per month TARP funds of largest banks repaid at a profit to taxpayers: JPMorgan (6/09); Bank of America, Wells Fargo, Citi (12/09) NBER dates June 2009 as official recession end (9/10) Fallout through 2011 FDIC s problem list reaches a peak asset total of $431 billion (3/10) and peak number of 888 banks (3/11). Roughly 400 smaller banks still owe nearly $2 billion in TARP funds (10/11). Only two of the 249 banks that failed in 2010 and 2011 held more than $5 billion in assets (12/11). Foreclosure procedures questioned, halted and federally mandated to be improved at several major banks/mortgage servicers (10/10) Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Annual Report 2011 Annual Report 9

11 The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance. Box 1 Degrees of Failure: Bankruptcies, Buyouts and Bailouts F or capitalist economies to thrive, weak companies must go out of business. The reasons for failure vary from outdated products, excess industry capacity, mismanagement and simple bad luck. The demise of existing firms helps the economy by freeing up resources for new enterprises, leaving healthier survivors in place. Joseph Schumpeter coined the term creative destruction to describe this failure and renewal process a major driver of progress in a free-enterprise economy. Schumpeter and his disciples view this process as beneficial despite the accompanying loss of jobs, asset values and equity. The U.S. economy offers a range of options for this process of failure and rebirth: Bankruptcies Enterprises beyond saving wind up in Chapter 7 bankruptcy, with operations ended and assets sold off. Firms with a viable business but too much debt or other contractual obligations usually file for Chapter 11 bankruptcy, continuing to operate under court protection from creditors. Both forms of bankruptcy result in a hit to stakeholders: shareholders, employees, top managers and creditors are wiped out or allowed to survive at a significant haircut. Bankruptcy means liquidation or reduction; whether the bankrupt firm dies completely or scales down and survives with the same or similar name, the end game is reallocation of resources. Buyouts A company facing potential bankruptcy may instead be sold. The acquisition usually produces similar stakeholder reduction results as a Chapter 11 bankruptcy, but without the obliteration of equity ownership and creditor fallout. Bailouts The government steps in to prevent bankruptcy by providing loans or new capital. The government becomes the most senior secured creditor and begins downsizing losses, management, the corporate balance sheet and risk appetite. As the company restructures, the government, often very slowly, weans the company off life support. Banks are special The FDIC handles most bank failures through a resolution similar to a private-sector buyout. The FDIC is funded primarily by fees garnered from the banking industry. The failed institution s shareholders, employees, management and unsecured creditors still generally suffer significant losses, while insured depositors are protected. In the wake of the financial crisis, Dodd Frank added a new option: the Orderly Liquidation Authority (OLA). In theory, OLA will follow the spirit of a Chapter 7 bankruptcy liquidation of the failed firm s assets but in an orderly manner. Orderly may involve some FDIC/government financing to maximize firm value prior to the sale, thus blending some of the degrees of failure already discussed. Buyouts, bankruptcies and FDIC resolutions have a long history of providing a reasonably predictable process that imposes no costs to taxpayers. Bankruptcies and buyouts support creative destruction using private sector funding. By contrast, bailouts and OLA are specifically aimed at dealing with too-big-to-fail institutions and are likely to involve some form of taxpayer assistance since this degree of failure comes after private sector solutions are deemed unavailable. Bailouts provide delayed support of the creative destruction process, using sometimes politically influenced taxpayer funds instead of the free-enterprise route of reduction, rebirth and reallocation. In essence, dealing with TBTF financial institutions necessitates quasi-nationalization of a private company, a process antithetical to a capitalist system. But make no mistake about it: A bailout is a failure, just with a different label Annual Report

12 As housing markets deteriorated, policymakers became alarmed, seeing the number of big, globally interconnected banks among the wounded. The loss of even one of them, they feared, would create a domino effect that would lead to a collapse of the payment system and severely damage an economy already battered by the housing bust. Capital markets did in fact seize up when Lehman Brothers, the fourth-largest investment bank, declared bankruptcy in September To prevent a complete collapse of the financial system and to unfreeze the flow of finance, the expedient fix was hundreds of billions of dollars in federal government loans to keep these institutions and the financial system afloat. In short, the situation in 2008 removed any doubt that several of the largest U.S. banks were too big to fail. 4 At that time, no agency compiled, let alone published, a list of TBTF institutions. Nor did any bank advertise itself to be TBTF. In fact, TBTF did not exist explicitly, in law or policy and the term itself disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance (Exhibit 4). 5 Most of the largest financial institutions did not fail in the strictest sense. However, bankruptcies, buyouts and bailouts facilitated by the government nonetheless constitute failure (Box 1). The U.S. financial institutions that failed outright between 2008 and 2011 numbered more than 400 the most since the 1980s. The housing bust and recession disabled the financial system, stranding many institutions on the roadway, creating unprecedented traffic jams. Struggling Exhibit 4 Total Assets of Failed and Assisted Institutions Reached Extraordinary Levels Total assets (billions of dollars) ,000 1,000 SOURCE: Federal Deposit Insurance Corp $3,223 assisted 1, Assisted institutions , $3.77 trillion total failed/assisted 94 Failed institutions $542 failed Annual Report 11

13 Psychological side effects of TBTF can t be measured, but they re too important to ignore because they affect economic behavior. Exhibit 5 Positive Feedback Employment increases Vehicle, home and durable good sales increase Credit expands Real income grows Progressing Expansion Good begets good Equipment, software and other business investments increase Spending increases Real economy expands Profits increase banks could not lend, slowing economic activity. Massive layoffs followed, pinching household and business spending, which depressed stock prices and home values, further reducing lending. These troubles brought more layoffs, further reducing spending. Overall economic activity bogged down. The chain reaction that started in December 2007 became the longest recession in the post-world War II era, lasting a total of 18 months to June Real output from peak to trough dropped 5.1 percent. Job losses reached nearly 9 million. Unemployment peaked at 10 percent in October The economy began seeing a slight easing of congestion in mid With the roadway beginning to clear of obstacles, households and businesses sensed an opportunity to speed up. New jobs, higher spending, rising asset prices and increased lending all reinforce each other, building up strength as the economy proceeds on a growth path (Exhibit 5). Monetary Policy Engine In an internal combustion engine, small explosions in the cylinders combus Annual Report

14 tion chambers propel a vehicle; likewise, the monetary policy engine operates through cylinders that transmit the impact of Fed actions to decisions made by businesses, lenders, borrowers and consumers (Exhibit 6). 6 When it wants to get the economy moving faster, the Fed reduces its policy interest rate the federal funds rate, what banks charge one another for overnight loans. Banks usually respond by making more credit available at lower rates, adding a spark to the bank loan cylinder that drives borrowing by consumers and companies. Subsequent buying and hiring boost the economy. Interest rates in money and capital markets generally fall along with the federal funds rate. The reduced cost of financing taking place in the securities market cylinder enables many large businesses to finance expansion through sales of stock, bonds and other instruments. Increased activity occurs in the asset prices and wealth cylinder stemming from the propensity of falling interest rates to push up the value of assets bonds, equities, homes and other real estate. Rising asset values bolster businesses balance sheets and consumers wealth, leading to greater capacity to borrow and spend. Declining interest rates stimulate activity in the exchange rate cylinder, making investing in U.S. assets less attractive relative to other countries, putting downward pressure on the dollar. The exchange rate adjustments make U.S. exports cheaper, stimulating employment and economic activity in export industries. However, what other countries do is important; if they also lower interest rates, then the effect on exchange rates and exports will be muted. From the first moments of the financial crisis, the Fed has worked diligently often quite imaginatively to repair damage to the banking and financial sectors, fight the recession, clear away impediments and jump-start the economy. The Fed has kept the federal funds rate close to zero since December To deal with the zero lower bound on the federal funds rate, the Fed has injected billions of dollars into the economy by purchasing long-maturity assets on a massive scale, creating an unprecedented bulge in its balance sheet. That has helped push down borrowing costs at all maturities to their lowest levels in more than a half century. While reducing the interest burden for borrowers, monetary policy in recent years has had a punishing impact on savers, particularly those dependent on shrinking interest payments. In the United States, economic growth resumed in mid-2009 but it has been tenuous and fragile through its first two-plus years. Annual growth has averaged about 2.5 percent, one of the weakest rebounds of any post-wwii recovery. Stock prices quickly bounced back from their recessionary lows but seem suspended in trendless volatility. Home prices have languished. At the same time, job gains have been disappointing, averaging 120,000 a month from January 2010 to December 2011, less than half what they were in the midto late 1990s when the labor force was considerably smaller. Through 2011, only a third of the jobs lost in the recession have been regained. What s Different Now? The sluggish recovery has confounded monetary policy. Much more modest Fed actions have produced much stronger results in the past. So, what s different now? 2011 Annual Report 13

15 A vehicle s engine with one cylinder misfiring may get you where you want to go; it just takes longer. The same goes for the machinery of monetary policy, largely because of the interdependence of all the moving parts. Exhibit 6 The Four Cylinders of the Monetary Policy Engine Bank loan Securities market Crankshaft Asset prices and wealth Bank capital lubricant Exchange rate Connected to economy: households, businesses and governments Part of the answer lies in excesses that haven t been wrung out of the economy falling housing prices have been a lingering drag. Jump-starting the housing market would surely spur growth, but TBTF banks remain at the epicenter of the foreclosure mess and the backlog of toxic assets standing in the way of a housing revival. Mortgage credit standards remain relatively tight. 7 Loan demand lags because of uncertainty about the economic outlook and diminished faith in American capitalism. Even though banks have begun easing lending standards, potential borrowers believe the tight credit standards of remain in place. Another part of the answer centers on the monetary policy engine. It still isn t hitting on all cylinders, impairing the Fed s ability to stimulate the real economy s growth of output and employment. As a result, historically low federal funds rates haven t delivered a large expansion of overall credit. With bank lending weak, financial markets couldn t play their usual role in recovery revving up lending by nonbanks to the household and business sectors. A vehicle s engine with one cylinder Annual Report

16 misfiring may get you where you want to go; it just takes longer. The same goes for the machinery of monetary policy, largely because of the interdependence of all the moving parts. When one is malfunctioning, it degrades the rest. A scarcity of bank credit, for example, inhibits firms capacity to increase output for exports, undermining the power within the exchange rate cylinder. Similarly, the contributions to recovery from securities markets and asset prices and wealth have been weaker than expected. A prime reason is that burned investors demand higher-than-normal compensation for investing in private-sector projects. They remain uncertain about whether the financial system has been fixed and whether an economic recovery is sustainable. They worry about additional financial shocks such as the euro zone crisis. Sludge on the Crankshaft A fine-tuned financial system requires well-capitalized banks, with the resources to cover losses from bad loans and investments. In essence, bank capital is a key lubricant in the economic engine (see Exhibit 6). Insufficient capital creates a grinding friction that weakens the entire financial system. Bank capital is an issue of regulatory policy, not monetary policy. But monetary policy cannot be effective when a major portion of the banking system is undercapitalized. The machinery of monetary policy hasn t worked well in the current recovery. The primary reason: TBTF financial institutions. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years. In contrast, the nation s smaller banks are in somewhat better shape by some measures. Before the financial crisis, most didn t make big bets on mortgage-backed securities, derivatives and other highly risky assets whose value imploded. Those that did were closed by the Federal Deposit Insurance Corp. (FDIC), a government agency. Coming out of the crisis, the surviving small banks had healthier balance sheets. However, smaller banks comprise only onesixth of the banking system s capacity and can t provide the financial clout needed for a strong economic rebound. The rationale for providing public funds to TBTF banks was preserving the financial system and staving off an even worse recession. The episode had its downside because most Americans came away from the financial crisis believing that economic policy favors the big and wellconnected. They saw a topsy-turvy world that rewarded many of the largest financial institutions, banks and nonbanks alike, that lost risky bets and drove the economy into a ditch. 8 These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself (Box 2). These psychological side effects of TBTF can t be measured, but they re too important to ignore because they affect economic behavior. People disillusioned with capitalism aren t as eager to engage in productive activities. They re likely to approach economic decisions with suspicion and cynicism, shying away from the risk taking that drives entrepreneurial capitalism. The ebbing of faith has added friction to an economy trying to regain cruising speed. Shifting into Gear Looking back at the financial crisis, recession and the tepid recovery that followed points to two challenges facing the U.S. economy in 2012 and beyond. The short term demands a focus on repairing the 2011 Annual Report 15

17 The verdict on Dodd Frank will depend on what the final rules look like. So far, the new law hasn t helped revive the economy and may have inadvertently undermined growth. Box 2 TBTF: A Perversion of Capitalism A n unfortunate side effect of the government s massive aid to TBTF banks has been an erosion of faith in American capitalism. Ordinary workers and consumers who might usually thank capitalism for their higher living standards have seen a perverse side of the system, where they see that normal rules of markets don t apply to the rich, powerful and well-connected. Here are some ways TBTF has violated basic tenets of a capitalist system: Capitalism requires the freedom to succeed and the freedom to fail. Hard work and good decisions should be rewarded. Perhaps more important, bad decisions should lead to failure openly and publicly. Economist Allan Meltzer put it this way: Capitalism without failure is like religion without sin. Capitalism requires government to enforce the rule of law. This requires maintaining a level playing field. The privatization of profits and socialization of losses is completely unacceptable. TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful. Capitalism requires businesses and individuals be held accountable for the consequences of their actions. Accountability is a key ingredient for maintaining public faith in the economic system. The perception and the reality is that virtually nobody has been punished or held accountable for their roles in the financial crisis. The idea that some institutions are TBTF inexorably erodes the foundations of our market-based system of capitalism Annual Report

18 financial system s machinery, so the impacts of monetary policy can be transmitted to the economy quickly and with greater force. To secure the long term, the country must find a way to ensure that taxpayers won t be on the hook for another massive bailout. Both challenges require dealing with the threat posed by TBTF financial institutions; otherwise, it will be difficult to restore confidence in the financial system and the capitalist economy that depends on it. The government s principal response to the financial crisis has been the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank), signed into law on July 21, It s a sprawling, complex piece of legislation, addressing issues as diverse as banks debit card fees and systemic risk to the financial system. Since Dodd Frank became law, at least a dozen agencies, including the Fed, have been working to translate its provisions into regulations to govern the financial system. They re unlikely to finish until 2013 at the earliest. The verdict on Dodd Frank will depend on what the final rules look like. So far, the new law hasn t helped revive the economy and may have inadvertently undermined growth by adding to uncertainty about the future. A prolonged legislative process preceded the protracted implementation period, with bureaucratic procedure trumping decisiveness. Neither banks nor financial markets know what the new rules will be, and the lack of clarity is delaying repair of the bank-lending and financial market parts of the monetary policy engine. The law s sheer length, breadth and complexity create an obstacle to transparency, which may deepen Main Street s distrust of Washington and Wall Street, especially as big institutions use their lawyers and lobbyists to protect their turf. At the same time, small banks worry about a massive increase in compliance burdens. Policymakers can make their most immediate impact by requiring banks to hold additional capital, providing added protection against bad loans and investments. In the years leading up to the financial crisis, TBTF banks squeezed equity to a minimum. They ran into trouble because they used piles of debt to expand risky investments in the end finding that excessive leverage is lethal. The new regulations should establish basic capital levels for all financial institutions, tacking on additional requirements for the big banks that pose systemic risk, hold the riskiest assets and venture into the more exotic realms of the financial landscape. 9 Mandating larger capital cushions tied to size, complexity and business lines will give TBTF institutions more skin in the game and restore some badly needed market discipline. Overall, the revised regulatory scheme should provide incentives to cut risk. Some banks may even rethink their mania for growing bigger. Higher capital requirements across the board could burden smaller banks and probably further crimp lending. These institutions didn t ignite the financial crisis. They didn t get much of a helping hand from Uncle Sam. They tend to stick to traditional banking practices. They shouldn t face the same regulatory burdens as the big banks that follow risky business models. TBTF banks sheer size and their presumed guarantee of government help in time of crisis have provided a significant edge perhaps a percentage point or more in the cost of raising funds. 10 Making these institutions hold added capital will level the playing field for all banks, large and small Annual Report 17

19 Higher capital requirements across the board could burden smaller banks and probably further crimp lending. These institutions shouldn t face the same regulatory burdens as the big banks that follow risky business models. Facing higher capital requirements, the biggest banks will need to raise additional equity through stock offerings or increased retained earnings through reduced dividends. Attracting new investment will be comparatively less burdensome for the healthiest institutions, difficult for many and daunting for the weaker banks. Dodd Frank leaves the details for rebuilding capital to several supervisory agencies. The specifics are still being worked out; it appears banks will have until 2016 or 2017 to meet the higher thresholds. Given the urgent need for restoring the vitality of the banking industry, this may seem a long wait. However, capital rebuilding will likely take place faster as the stronger banks recognize the advantages of being first movers. Recently, many of the largest banks have made efforts to raise capital and have met or surpassed supervisory expectations for capital adequacy under stress tests. 11 Banks that quickly clean up their balance sheets will have a better chance of raising new funds so they can then be in shape to attract even more new capital. Past evidence shows that financial markets favor institutions that offer the best prospects for returns with acceptable risk. 12 Laggards will be worse off, finding it even more difficult to attract new investors. Ultimately, these institutions will further weaken and may need to be broken up, their viable parts sold off to competitors. With the industry already too concentrated, it s important to redistribute these banking assets in a way that enhances overall competition. Ensuring that banks have adequate capital is essential to effective monetary policy. It comes back to the bank capital linkage, which recognizes that banks must have healthy capital ratios to expand lending and absorb losses that normally occur. Repairing the damaged mechanism through which monetary policy impacts the economy will be the key to accelerating positive feedbacks. To some extent, the Fed s zero interest rate policy, adopted in December 2008 at the height of the financial crisis, assisted the banking industry s capital rebuilding process. It reduced banks costs of funds and enhanced profitability. But short-term interest rates cannot cross the zero lower bound, limiting any additional impact from this capital-building mechanism. It could Annual Report

20 be argued that zero interest rates are taxing savers to pay for the recapitalization of the TBTF banks whose dire problems brought about the calamity that created the original need for the zero interest rate policy. Unfortunately, the sluggish recovery is a cost of the long delay in establishing the new standards for bank capital. Given the urgent need to restore economic growth and a healthy job market, the guiding principles for bank capital regulation should be: codify and clarify, quickly. There is no statutory mandate to write hundreds of pages of regulations and hundreds more pages of commentary and interpretation. Millions of jobs hang in the balance. A Potential Roadblock Dodd Frank says explicitly that American taxpayers won t again ride to the rescue of troubled financial institutions. It proposes to minimize the possibility of an Armageddon by revamping the regulatory architecture. As part of its strategy to end TBTF, Dodd Frank expanded the powers of the Fed, FDIC and most other existing regulators. New watchdogs will be put on alert. A 10-member Financial Stability Oversight Council (FSOC), aided by a new Office of Financial Research, has been charged with monitoring systemic risk. It will try to identify and resolve problems at big banks and other financial institutions before they threaten the financial system. In an effort to increase transparency, much of the new information will be made public. Opaque business practices thwart market discipline. Can Dodd Frank do what was unthinkable back in 2008 identify and liquidate systemically important financial institutions in an orderly manner that minimizes risk to the financial system and economy? The current remedy for insolvent institutions works well for smaller banks, protecting customers money while the FDIC arranges sales or mergers that transfer assets and deposits to healthy competitors. During the financial crisis, however, the FDIC didn t have the staff, financial resources and time to wind down the activities of even one truly mammoth bank. Thus, many TBTF institutions stayed in business through government support. 13 Dodd Frank envisions new procedures for troubled big banks and financial institutions, directed by the FSOC watchdog and funded by fees charged to the biggest financial institutions. The goal is an alternative to the TBTF rescues of the past three decades. In practice, these rescues have penalized equity holders while protecting bond holders and, to a lesser extent, bank managers. Disciplining the management of big banks, just as happens at smaller banks, would reassure a public angry with those whose reckless decisions necessitated government assistance. Will the new resolution procedures be adequate in a major financial crisis? Big banks often follow parallel business strategies and hold similar assets. In hard times, odds are that several big financial institutions will get into trouble at the same time. 14 Liquid assets are a lot less liquid if these institutions try to sell them at the same time. A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF too many to fail, as happened in A second important issue is credibility. Going into the financial crisis, markets assumed there was government backing for Fannie Mae and Freddie Mac bonds 2011 Annual Report 19

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